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Penalty clauses in construction contracts

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Earlier this month the Supreme Court gave judgment in two combined cases concerning the law relating to contractual penalty clauses. In Cavendish Square Holdings BV v Talal El Makdessi and ParkingEye Ltd v Beavis [2015] UKSC 67, the Supreme Court had the opportunity to review the law on penalties for the first time since the House of Lords case of Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co. Ltd [1915] A.C. 847 a century ago. In both cases, the Supreme Court held that the clauses were valid and enforceable, overturning the Court of Appeal’s decision in Cavendish (which was considered in a GD Online article of February 2014) and upholding the Court of Appeal’s decision in ParkingEye.

Whilst Cavendish and ParkingEye are not related specifically to construction contracts, these cases will have a significant impact on how liquidated damages provisions in construction contracts are likely to be interpreted going forwards.

Penalty Clauses: The law before Cavendish and ParkingEye

It is a long-established rule of law that a clause which is deemed to be a penalty will be unenforceable. Liquidated damages clauses, by contrast, are enforceable. The purpose of a liquidated damages clause is to compensate the innocent party for breach of the terms of an agreement without the difficulty and expense of having to prove the actual loss. A penalty clause, on the other hand, functions to punish or deter a party from breaching the terms of an agreement and may well be disproportionate to the actual loss suffered by the aggrieved party.

The traditional approach in identifying a penalty clause, laid down in Dunlop, was to consider whether the specified damages were “a genuine pre-estimate of loss or a deterrent” – if the former, they were not a penalty.

Penalty Clauses: The law after Cavendish and ParkingEye

In Cavendish and ParkingEye, the Supreme Court was unanimous that the doctrine of penalties should not be abolished, but extended the traditional test set down in Dunlop, and provided useful clarification on subsequent case lawThe Supreme Court held that:

  1. The rule on penalties only applies to “secondary obligations”, meaning obligations which only arise out of a breach of contract.
  2. The tests set out in in Dunlop will usually be adequate to determine the validity of a straightforward damages clause.
  3. In other cases, the concepts of ‘genuine pre-estimate of loss’ and ‘deterrence’ are unhelpful.  The true test is “whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.”

In order to determine whether or not a clause is a penalty, the key therefore is to consider whether the liquidated damages clause is out of all proportion to the employer’s legitimate interest in enforcing the contractor’s obligations under the contract. If it is, it will be penal and unenforceable.

The Impact on Construction Contracts

Construction contracts will often contain liquidated damages clauses in the event of certain specified breaches occurring. The most common example is a failure to complete the works within a specified time. In many ‘routine’ construction projects (such as office blocks), financial compensation will often be sufficient to provide an employer with a remedy for a delay in completion. However, in other projects a delay in completion can result in losses which cannot be met by financial compensation alone. For example, delay in the completion of a sports venue for a specific event (such as a World Cup) carries great risk of reputational damage and loss of goodwill.

In such circumstances the employer’s interest in timely completion may not be met fully by financial compensation. It is in these situations that the new test set out by the Supreme Court is likely to have a significant effect.

Going forward, parties to a construction contract will need to consider the realistic commercial impact of a breach, taking into account losses that are not easily quantifiable (such as reputational damage, loss of goodwill and third party interests). Such losses will fall under the banner of “commercial interests”. Any liquidated damages clause will need to be drafted to reflect the employer’s “legitimate interests” as accurately as possible, but care must be taken to ensure that the redress is not “out of all proportion”, so as to amount to a penalty clause.

It is worth bearing in mind that the law of penalties has always been recognised as interfering with the principle of freedom of contract, and is one of the few exceptions to this principle. Although the Supreme Court did not act to abolish penalties, it did make clear, as a general rule, that in a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach.

Comment

This judgment provides welcome clarification of the law in this area, setting out an updated test for penalty clauses and guidance on how this should be applied to modern commercial contracts. In construction contracts, the new test will require commercial justification for the liquidated damages clause at the time the contract was entered into, and consideration of whether it is out of all proportion to the employer’s legitimate commercial interest in the works completing on time.

However, the meaning of a “legitimate interest” and what is “out of all proportion” are likely to form the new battleground for future challenges to the validity of liquidated damages clauses. No doubt satellite litigation on these points will test the boundaries of Supreme Court’s decision and provide further clarification in due course.

This guide is for general information and interest only and should not be relied upon as providing specific legal advice.  If you require any further information about the issues raised in this article please contact the author or call 0207 404 0606 and ask to speak to your usual Goodman Derrick contact.